Troubled Debt Restructuring Example 1

Troubled Debt Restructuring Example 1 1. Viola Vacations signed a note to Empire Airways in the amount of $50,000. The terms specified annual 10% interest payments on the unpaid balance. The note is due today. Viola Vacations has not paid the interest for the last year and is unable to pay anything on the principal due. 2. Empire has agreed to a concession which involves the transfer of noncash items with a market value of less than the $55,000 amount of the pastdue debt ($50,000 principal, $5,000 accrued interest already debited to interest expense and credited to interest payable). 3. Viola Vacations will transfer a parcel of real estate to Empire. The fair market value of the land (per the appraisal) is $30,000. Viola Vacations had purchased the land several years ago for $10,000. Creditor s Books Debit Credit Land 30,000 Comparison to IFRS: Notes receivable 50,000 Is revaluation possible? Interest receivable 5,000 Allow for bad debts 25,000 Is this "fair value" accounting? Loan Impairment wip 9Sep10.xlsx Example 1 Page 1

Troubled Debt Restructuring Example 2 1. Viola Vacations signed a note to Empire Airways in the amount of $50,000. The terms specified annual 10% interest payments on the unpaid balance. The note is due today. Viola Vacations has not paid the interest for the last year and is unable to pay anything on the principal due. 2. Empire has agreed to a concession which involves the transfer of noncash items with a market value of less than the $55,000 amount of the pastdue debt ($50,000 principal, $5,000 accrued interest already debited to interest expense and credited to interest payable). 3. Viola Vacations will issue to Empire Airways 4,000 shares (a 10% ownership interest) of its common stock which has a par value of $10 and has been estimated to be worth $12 per share. In return, Empire Airways will accept the stock in full settlement of the debt principal and accrued interest (i.e., $55,000). Creditor s Books Debit Credit What type of investment? Investment Portfolio 48,000 Trading Notes receivable 50,000 Available for sale Interest receivable 5,000 Equity method Allow for bad debts 7,000 Cost method Loss on troubled debt restructuring 4000 12 48000 55000 7000 Is this "fair value" accounting? Loan Impairment wip 9Sep10.xlsx Example 2 Page 1

Troubled Debt - Example 3 - CREDITOR TROUBLED DEBT RESTRUCTURING DEMONSTRATION PROBLEM #3 - DEBTOR 1. Farview Farms had signed a $40,000 note to Idaho First Bank and Trust. The note specified annual payments of $10,000 per year plus 12% interest on the unpaid balance. Unseasonable weather two years in a row has ruined the crops which Farview intended to sell to make its loan payments. The bank has agreed to restructure the terms of the loan. [Assume that Farview has already recorded as interest expense the $4,800 unpaid accrued interest.] Carry9ng value of old debt $ 44,800.00 PV of fitire cash flows $ 27,481 loss $ (17,319) 2. The new loan agreement specifies an immediate payment of $4,000 which represents 10% interest on the balance which was outstanding during the year. Farview will then pay interest only for three years at a 10% rate on a reduced principal amount of $25,000. Four years from now, the balloon payment of $27,500 (principal + interest) will come due. Find present value of cash flows using historical interest rate i= 12% n= 4 pmt= 2500 FV= 25000 $ $ Immediate payment (pv of $1 now is $1) Creditor s Books Debit Credit PV= 23,481 At date of restructure: ADD 4,000 Cash $ 4,000 PV= $ 27,481 before payment of interest Accrued Interest Receivable $ 4,800 Creditor s New Amortization Table: Note Receivable (old) $ 40,000 Period Cash Flows Interest Difference Note Receivable (restructured) $ 23,481 0 12% 27,481 Allowance for doubtful accounts $ 17,319 0 4,000 23,481 Alt: Loss on TDR $ 44,800 $ 44,800 1 2,500 2,818 318 23,799 End of year 1 2 2,500 2,856 356 24,155 Cash $ 2,500 3 2,500 2,899 399 24,554 Interest revenue $ 2,818 4 2,500 2,946 446 25,000 Notes receivable (restructured) $ 318 25,000 0 End of year 2 Cash $ 2,500 Interest revenue $ 2,856 Notes receivable (restructured) $ 356 Carrying Loan Impairment wip 9Sep10.xlsx Ex 3 - Creditor Page 1

Example 3 - creditor (continued) Cost Recovery Method (FAS 118 Amendment to FAS 114) Under FAS 114 troubled debt accounting required creditors to use the interest method to recognize interest income on the restructured debt. Many financial institutions objected to this procedure because it caused them to recognize revenue that would later have to be written off as a loss if the debtor was unable to meet the terms of the restructured debt. Under the amendment, creditors are permitted to use other revenue recognition methods such as the cost recovery method. This method assumes that all cash collected goes toward principle until the entire amount has been recovered. If the creditors in the demonstration problems used cost recovery method instead, they would recognize revenue as shown below -- no interest income would ever be recorded. Creditor s Books Debit Credit Troubled Debt Demonstration Problem #3 At date of restructure: Period Cash Rec'd Principal Recognized Received Cash $ 4,000 27,481 Accrued Interest Receivable $ 4,800 0 4,000 23,481 Note Receivable (old) $ 40,000 1 2,500 0 2,500 20,981 Note Receivable (restructured) $ 23,481 2 2,500 0 2,500 18,481 Allowance for doubtful accounts $ 17,319 3 2,500 0 2,500 15,981 same as effecive interest method 4 27,500 11,519 15,981 0 End of year 1, 2 and 3 Totals 39,000 11,519 23,481 Cash $ 2,500 PV 27,481 Notes receivable (restructured) $ 2,500 11,519 End of year 4 Cash $ 27,500 Notes receivable (restructured) $ 15,981 Income realized on impaired loans $ 11,519 $ 74,800 $ 74,800 Carrying Loan Impairment wip 9Sep10.xlsx Ex 3 - Creditor Page 2

Troubled Debt Example 4 - CREDITOR 1. Farview Farms had signed a $40,000 note to Idaho First Bank and Trust. The note specified annual payments of $10,000 per year plus 12% interest on the unpaid balance. Unseasonable weather two years in a row has ruined the crops upon which Farview intended to sell to makes it loan payments. The bank has agreed to restructure the terms of the loan. [Assume that Farview has already recorded as interest expense the $4,800 unpaid accrued interest.] 2. The new loan agreement specifies no immediate payments. Farview will pay interest only for three years at a 11% rate on a reduced principal amount of $35,000. Four years from now, the balloon payment will come due, i.e., $38,850 principal plus interest. Find present value of cash flows using historical interest rate i= 12% ALWAYS USE HISTORICAL RATE n= 4 pmt= 3850 35000 11% 3850 FV= 35000 PV= $ (33,937) ADD $ - Immediate pymt (pv of $1 now = $1) PV= before payment of interest Creditor s Books Debit Credit At date of restructure: Creditor s New Amortization Table: effective in Cash $ - Period Cash Flows Interest Difference Carrying Accrued Interest Receivable $ 4,800 0 12% Note Receivable (old) $ 40,000 0 33,937 Note Receivable (restructured) $ 33,937 1 3,850 4,072 222 34,159 Allowance for doubtful accounts $ 10,863 2 3,850 4,099 249 34,408 Effective interest method: 3 3,850 4,129 279 34,688 End of year 1 4 3,850 4,163 313 35,000 Cash $ 3,850 4 35,000 0 Interest revenue $ 4,072 total interest= 16,463 Notes receivable (restructured) $ 222 Creditor s New Amortization Table: cost recove $ 48,872 48,872 Period Cash Flows Interest $ 0 12% Difference 0 33,937 What if we used cost recovery method? 1 3,850 0-3,850 30,087 Yr 1 Cash 3850 2 3,850 0-3,850 26,237 N/R restructured 3850 3 3,850 0-3,850 22,387 4 3,850 0-3,850 18,537 4 35,000 16,463 18,537 0 Add total cash flows 50400 PV of the cash flows 33,937 to recognize 16,463 Carrying Loan Impairment wip 9Sep10.xlsx Ex 4 - Creditor Page 1

Troubled Debt - Example 5 - CREDITOR Troubled Debt (Question from F06 Exam 1). Bobs Brakes Inc. is a major creditor of Adam s Auto Repair Inc. Adam s Auto Repair Inc. is experiencing substantial financial difficulties. Its original note with Bobs Brakes Inc. was dated August 1, 2005 and has a face value of $100,000 and specified a 10% interest rate. The interest for the year ending August 1, 2006 has not been paid. On August 1, 2006, the debtor persuaded Bobs Brakes to reduce the principal from $100,000 to $70,000 and to reduce interest payments to $3,500 per year for the remaining 3-year life of the debt. The modified terms also waive payment of the accrued interest currently due. Both debtor and creditor have fiscal years that coincide with the calendar year. Assume accrued interest receivable has already been booked. (48,704) new Find present value of cash flows using historical interest rate i= 10% n= 3 pmt= -3500 FV= -70000 PV= $ 61,296 ADD $ - Immediate payment (pv of $1 now = $1) PV= $ 61,296 before payment of interest $ 110,000 carrying value $ loss Creditor s Books Debit Credit 8/1/2006 Note receivable (old) $ 100,000 Acc'd Interest Receivable $ 10,000 10% Restructured note receivable (NEW) $ 61,296 Creditor s New Amortization Table: Allowance for bad loans (OR LOSS ON RESTRUCTURING) $ 48,704 Period Cash Flows Interest Difference Carrying 0 effective interest method 0 5 monthsto accrue 1 61,296 12/31/2006 Interest receivable (5/12 * 3500) $ 1,458 2 3,500 6,130 2,630 63,926 Interest revenue 5/12 * 6130 $ 2,554 3 3,500 6,393 2,893 66,818 Note receivable (5/12 * 2630) $ 1,096 4 3,500 6,682 3,182 70,000 4 70,000 8/1/2007 Cash $ 3,500 Interest receivable $ 1,458 spread between 06 & 07 Interst revenues (7/12 * 6130) $ 3,576 Note receivable (plug) $ 1,534 $ 117,588 $ 117,588 TRUE Loan Impairment wip 9Sep10.xlsx Ex 5 - Creditor Page 1

IFRS vs. US GAAP - Loan Impairment (creditor) 6-9. On December 31, 2006, Jones Company sold manufacturing equipment to Steel Corporation. Steel Corporation gave Jones Company a 5 year $200,000, zero interest note. The market rate of interest for a note with similar risks is 10%. At December 31, 2008 Jones Company reviews its financial assets for impairment. Jones Company concludes that the value of the note is impaired and it only expects to collect $150,000 of the principal at maturity. By December 31, 2009 Jones Company has determined they will probably collect $160,000 on the manufacturing equipment. Prepare the appropriate journal entries for December 31, 2008 and December 31, 2009 according to a) IFRS b) US GAAP. Explain why the journal entries differ under the two sets of standards. Creditor s Books Debit Credit At loan initiation, record sales at PV of cash flows i= 10% n= 5 pmt= 0 0% rate FV= $ (200,000) PV= $ 124,184 US GAAP & IFRS At origination of loan 12/31/2006 Creditor s Original Amortization Table: Period Cash Flows Interest Difference 12/31/2006 Initiation of loan Table 1 Note receivable $ 124,184 12/31/2006 0 10% 124,184 Sales $ 124,184 12/31/2007 1 0 12,418 12,418 136,602 COGS xx 12/31/2008 2 0 13,660 13,660 150,263 Inventory xx 12/31/2009 3 0 15,026 15,026 165,289 [SAME UNDER IFRS & US GAAP] 12/31/2010 4 0 16,529 16,529 181,818 12/31/2011 5 0 18,182 18,182 200,000 12/31/2007 Recognition of interest revenue 12/31/2012 6 Interest revenue 12,418 Notes receivable 12,418 12/31/2008 12/31/2008 Recognition of interest revenue Loan impairment recognized Interest revenue 13,660 i= 10% Notes receivable 13,660 n= 3 pmt= 0 12/31/2008 Recognition of impairment FV= $ (150,000) US GAAP Note receivable (new) 112,697 12/31/2008 PV= $ 112,697 Allowance for doubtful accounts 37,565 $ 150,263 carrying value Notes receivable (old) 150,263 $ (37,565) impairment loss IFRS and US GAAP IFRS Notes receivable (new) 112,697 At date of impairment 12/31/2008 Provision for bad and doubtful debts 37,565 Note receivable (old) 150,263 Carrying Loan Impairment wip 9Sep10.xlsx Ex 6 IFRS Example Page 1

12/31/2009 Change in expectations US GAAP No change - we don't recognize recoveries of impairments previously recorded 12/31/2009 Note receivable 11,270 Table 2 Creditor s NEW Amortization Table after impairment: Period Cash Flows Interest Difference Book Interest revenue 11,270 12/31/2006 0 10% 12/31/2007 1 12/31/2010 Note receivable 12,397 12/31/2008 2 112,697 Interest revenue 12,397 12/31/2009 3 0 11,270 11,270 123,967 12/31/2010 4 0 12,397 12,397 136,363 12/31/2011 Assuming $160,000 is collected 12/31/2011 5 0 13,636 13,636 150,000 Cash 160,000 Interest revenue 13,636 Note receivable 13,636 150,000 Bad debt expense (reduction) 10,000 or "recovery of impaired loan" 648,089 648,091 FALSE 12/31/2009 Change in expectations Under IFRS, partial recovery recognized Recovery of impairments ARE acceptable i= 10% IFRS Note receivable 11,270 n= 2 PV= $ 132,231 Interest revenue 11,270 pmt= 0 carrying 123,967 Table 2 FV= 160000 8,265 loss recovey 12/31/2009 Notes receivable (new) 132,231 PV= $ 132,231 Provision for bad and doubtful debts 8,265 Notes receivable (old) 123,967 IFRS ONLY To adjust N/R for improved expectations At this point, the carrying value = new present Change in estimated value 12/31/2009 value of expected cash flows at original interest rate. IFRS ONLY - Creditor s NEW Amortization Table: 12/31/2010 Note receivable 13,223 Table 3 Period Cash Flows Interest Difference Carrying Interest revenue 13,223 12/31/2006 0 10% 12/31/2007 1 12/31/2008 2 12/31/2011 Assuming $160,000 is collected 12/31/2009 3 132,231 Cash 160,000 12/31/2010 4 0 13,223 13,223 145,455 Interest revenue 14,545 12/31/2011 5 0 14,545 14,545 160,000 Note receivable 14,545 160,000 Loan Impairment wip 9Sep10.xlsx Ex 6 IFRS Example Page 2